It is often referred to as a packet filter as it examines each packet transferred in every network connection to, from, and within your computer. iptables replaced ipchains in the 2.4 kernel and added many new features including connection tracking (also known as stateful packet filtering).1
This means that the configuration for the firewall is set to "deny all connections" by default and the only way to establish connections between to point or two entity, we have to explicitly add new rules for them.
The term "INPUT" refers to any packet that is coming to this computer, "OUTPUT" means any packet that is generated by this computer and is leaving it. The term "FORWARD" also means the packets that are arriving from another computer but their final destination is one other computer. In fact we have used this computer to transit the packets between two different computers. The term "DROP" means that "the packet is not allowed through the firewall and the sender of the packet is not notified."2
In our firewall rule set, as you have seen above in section one, all incoming and outgoing packets are dropped unless we add new rules that allow our system to deal with. We have only allowed the system to use one connection by defining only one connection named "eth0" in the rules as follows: